Bull Market in Metals Not Over Yet
by Michael Sabo
There have been some significant measures already made by the government and the Federal Reserve to help alleviate our economic malaise—including last week’s cut of 75 basis points in the Federal funds rate. And while we’ve had some positive news propping up the stock market--including an enlarged offer for Bear Stearns - there are still a lot of serious problems out on the horizon, and I think they run a lot deeper than many investors believe them to be.
We have seen some measures to restore confidence, which has caused the U.S. dollar to gain some strength, but what has really changed fundamentally in the past week? We still have credit problems, and I think they will continue to weigh on the economy. There are still a lot of layoff stories out there, and the economy is still under recessionary pressures. In fact, I think we are in a recession right now.
Market participants have gotten the sense the U.S. dollar is due for a corrective bounce, and we’ve seen a technical rebound in the past couple of sessions as participants cover short positions. As the dollar rebounded, silver and gold, which have been experiencing an inverse relationship to the dollar, fell from record highs. Does that mean the bull market in metals is over? In my opinion, no.
On a technical basis there has been some damage to the charts, but I think we had a market that had been a one-way trade, and needed to correct. Any small dip was met with buying, and prices kept moving up. Novice traders got caught in this frenzied buying, and we had a washout that knocked the weak longs out of the market. We also saw exchanges raise margins for gold and silver due to the increased volatility, and that threw more fuel on the fire. That put the less-capitalized players under further pressure, and enhanced the liquidation of long positions that took place. I don’t pick tops or bottoms in markets, but I think this washout in gold and silver may be nearing a bottom and the bullish trend should resume.
A Strategy for Silver
Looking at the chart of July silver, Thursday’s post-Fed meeting low of $16.80 an ounce has held. There may be some supporting news that China may be importing silver, but if you look at the weekly Commitments of Traders report, the speculative position is probably more balanced. I think a price around $17 an ounce for July futures should provide solid support, and the market remains above its 200-day moving average. I am still recommending a silver trade I outlined a few weeks ago, a ratio spread. To learn more about the details involved in this ratio spread strategy, you can read my March 6, 2008 article, Dollar Hits Record Low, Strategy for Silver.
It’s important to develop proper risk management strategies. It’s critical to understand what these markets are doing, and last week’s action drove that point home. I think silver still has more room to go on the upside before the bull-run ends. Even if you are long-term bullish and right about the trend, you have to protect your position so that the types of corrective moves like we saw last week don’t destroy your account in the meantime. If you have a sound risk-management plan in place you don’t mitigate your risk completely, but at least have a fighting chance of staying in the trade.
The 1x3 ratio spread in silver involved buying a $20 July silver call, and selling three July $25 calls against it, a slightly net short position according to the delta’s on the options. Even though this position is actually long-term bullish, the position offers the potential to provide a slight profit on a pullback. This spread simply means that we are bullish on the July silver futures, but at the same time, don’t expect prices to go to the moon by expiration. Your one long $20 call will cover one short $25 call. Basically, that’s like a bull spread, but you have two extra shorts out there, the $25 calls. The reason I recommend this is because you receive a lot of premium for those $25 calls, and you bring that premium in right away.
In a sense, you’re short, or naked, two $25 calls. When you apply the premium on the three that you sold, to the one that you bought, it costs you approximately 3 cents, or $150, not including commission costs. This position anticipates that the bull market in silver will continue, even with a short-term correction along the way. If you would like learn about how this strategy can be applied in other markets, you are always more than welcome to call me at 800-798-7671 to discuss these strategies.
In the wake of last week’s Federal Reserve policy meeting, the metals markets dropped sharply. Gold fell 8 percent last week, and silver declined 18 percent. You could take this trade off and walk away with a profitable position from your shorts. However, this position is not meant to capitalize on a decline, but rather, give you potential to weather through it. I’d recommend still holding these positions, as silver has a strong potential to move back up to our target price of $25. I think there is a double-top near $21, but I don’t see the highs yet in and there’s a strong chance for a new leg up.
This market is in the stages of a strong correction, and it’s doing what an efficient market would do. There is of course risk with this type of strategy. We want to see silver trade in a range. We don’t want silver to continue to fall down to $10 an ounce but if it did at expiration on June 25, if silver is at $10, you’ve made no money and lost no money (depending on where you got into the spread at). On the other hand, if silver is at $25 an ounce, the potential is $25,000 per ratio spread you do, not including your commission costs. Your breakeven is at aprox $27.50 per ounce on this trade. You make money at $26 but won’t realize the full profit potential. You make $6 on the $20 call and give $1 back on each of the $25 calls, so that’s $3 net gain, or $15,000. If silver is above $27.50 and you do nothing, your loss is virtually unlimited as you are short the two $25 calls. There are many different ways to reduce and manage the risk on the 2 naked $25 calls – please call me at 1-800-798-7671 so I can discuss further with you. Span Margin is roughly $2,500 to $3,000 for each of these that you do.
I like to use options as risk-management tools, but understand that this is just one of many strategies you can consider, some including both futures and options. If a client wants to pursue short-term swing trading I’d recommend a stop-loss. But if you are trying to stay in for a longer time to catch a larger move, it’s very difficult to risk a small amount in attempt to keep yourself in the market for three months or more. The volatility of these markets are so high and the ranges are so big. Unless you have deep pockets and a large account, you have to think strategy, ways to position yourself in case of different market scenarios. Don’t just put a position on and take a wait-and-see approach. That’s no way to trade in these markets. Be more strategic.
I still think this silver strategy is a solid play. If you’re interested, there is a lot to understanding this and I used numbers that are already in the past. If you would like to discuss the current market prices and how this trade would apply, you are more than welcome to call me for an update on this strategy. This can also be applied to other markets as well, but I think you have to be selective with them. Right now, I think this works very well with silver.
Michael Sabo is a Senior Market Strategist at Lind-Plus, Lind-Waldock’s broker-assisted division. He can be reached at 800-798-7671, or via email at msabo@lind-waldock.com.
Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
